Techniques for Accounting for Inventory

When running a business, one of the largest problems people have is keeping their inventory up to date

. This is a crucial part of successfully maximizing your profit margin, but many people fail to do so. To properly gage the appropriate prices of your products sold, you need to know the amount on hand, costs of those on hand and the costs of those goods sold. Although some of the most simple accounting principles and methods can easily keep your inventory on track, a lot of businesses seem to stray away from these obvious solutions to their inventory problem. Consider these four accounting methods most commonly used to assign costs to both inventory and cost of goods sold: the first-in, first-out (FIFO) method, the last-in, first-out (LIFO) method, the weighted average (average cost) method, and lastly specific identification. All four of these methods can help ensure that your business' inventory will be precise.

The first-in, first-out method assumes that inventory items are sold in the same order that those inventory items were purchased. When the inventory items are sold, the costs of the items first purchased are charged to the cost of goods sold. The costs from the most recent purchases are left in the ending inventory. One of the largest advantages to the FIFO method is that it factors in the costs to items that degrade or are damaged over time, so it does not turn up as a loss in the end of the period because you already accounted for it.

The second method used commonly is the last-in, first-out method which is the opposite of the first-in, first-out method, in that it assumes that the most recent inventory items purchased are sold first. The most recent costs of the purchases are charged to the goods sold, while the costs of the past purchases are assigned to the inventory. One of the largest draws to the last-in, first-out method is that it comes closest to matching current costs of goods sold with the current revenue because the most recent costs were assigned with the most recent purchases.

The weighted average method of assigning cost requires using the weighted average cost per unit of inventory during each sale. To find the weighted average cost per unit at the time of the sale, you need to divide the cost of goods available for sale by the current units available. The weighted average method gives the advantage to the business owner in that it equally accounts for the cost of each inventory item no matter when it was purchased or sold.

The fourth method commonly used is specific identification. Theoretically specific identification proves to be the most effective method because it takes the ending inventory of the period and directly correlates it with the specific costs of those goods. In doing so, it is shown that the cheapest goods were sold first which in the end will lower the cost of goods sold by increasing the ending inventories cost.

Although all four of these methods differ, they all share the same common goal of organizing your business' inventory. In theory, all of these methods will produce the same outcome if all of the inventory was sold, but in real life situations this is usually not the case.These methods should be chosen specifically for your company based on the advantages and disadvantages each one comes along with, based on what type of inventory you are dealing with. There is room for discussion for which method is better, but in the end all four of these methods will ensure improvement in managing your inventory costs and availability.

Techniques for Accounting for Inventory

By: Mark Gionta

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